What Is Debt Funding? Top 5 Reasons Why It Is Cheaper Than Equity Funding
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You can say it a usual thought process or a myth that no debt is good debt. Whenever we are talking about owing money these days, it’s almost always in a negative light. You hear it every day: homeowners are underwater, the national deficit is surging, consumers are saddled by shortsighted credit card spending, the nation’s graduates are buried under student loans.
For startups and small-medium businesses, the truth about debt is far less ominous. As the high finance set understands, not all borrowing is bad.
Small business owners often think that debt is bad and should be avoided. This most likely stems from the way debt is portrayed in the consumer media – from concerns about national borrowing, to consumers saddled by credit card spending and graduates weighted down by student loans. But borrowing (and lending) responsibly is actually a sensible thing for a business to do.
Defining in Simple Terms : Debt Funding
Debt funding means borrowing money and not giving up ownership. Debt funding often comes with strict conditions or covenants in addition to having to pay interest and principal at specified dates. Failure to meet the debt requirements will result in severe consequences.
The most common source of debt financing for startups often isn’t commercial lending/financial institution, but family and friends. When borrowing money from your relatives or friends, have your attorney draw up legal papers dictating the terms of the loan. Why? Because too many entrepreneurs borrow money from family and friends on an informal basis. The terms of the loan have been verbalized but not written down in a contract
How Debt funding is CHEAPER than Equity funding?
We understand this with a simple example here:
For example, if you run a small business and need 40,000 of financing, you can either take out a 40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbor for 40,000.
Suppose your business earns 20,000 profits during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be 4,000, leaving you with 16,000 in profit.
Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Thus, your personal profit would only be 15,000 (75% x 20,000).
From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you had debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity).
Top 5 Reasons That Proves Debt Funding Is Cheaper Than Equity Funding
1.Debt is usually less expensive than giving up equity in your company
Equity is always more expensive in the long-run than taking on debt especially; if your financial need is short term, seasonal or connected to working capital. Equity costs you a portion of your business and its profits, forever.
Equity funding means sacrificing both current and future value to fill a short to mid-term need. With debt, you incur interest costs, but it is temporary and capped. The cost of debt is in most cases easy to understand and clear at the point of purchase. On the other hand the cost of equity is not clear at the point of purchase and the process is more complex than with debt.
2. Debt funds an increase in working capital, supporting revenue growth
Suppose you lack the capital to buy inventory or hire staff to fulfil an order. The cost of goods sold is 50,000 and the revenue would be 100,000. Should you borrow 50,000 at a cost of 10,000 to fulfil the order?
In absolute terms, you’re making a 40,000 profit. In this case, the opportunity cost of avoiding 10,000 in interest is 40,000! Who wouldn’t be willing to pay 10,000 to make a 40,000 profit? That’s math anyone can understand.
If the opportunity is right, debt is often the better strategic choice. You can profit from debt and open up new growth channels.
The key question is: “Is the return from this investment higher than the cost of the debt available to me?” Whenever the return is higher, the debt is arguably worthwhile.
3: There is corporation tax relief on interest, which lowers the cost of borrowing
Many startup entrepreneurs aren’t aware of this surprise benefit of borrowing. The cost of interest reduces your taxable profit and, therefore, reduces your tax expense. The effective interest rate you’re paying is lower than the headline interest rate because of this.
Leveraged buyout firms have used this strategy for decades to improve their returns on equity investments. Small businesses, too, can use it to improve their company’s finances.
This further sets borrowing apart from selling equity as a means of financing your business growth. If you raise cash from equity, you will need to pay off that equity holder in the form of dividends, which gives you no corporation tax relief. Debt gives you the benefit of lower taxes.
4: Borrowing reduces hoarding of cash and profits, facilitating growth
Hoarding cash harms the business’ ability to invest profits and generate additional returns that are necessary to grow your business. If you hoard cash from a busy Diwali period in order to cover a cash shortage due in coming September as you are stocking up for Diwali again, you are not using your profits to grow for 10 whole months. Getting a short term working capital debt solution that you only pay for when you need it allows you to reinvest the profits from your busiest periods throughout the year.
5: Debt can improve financial discipline and business efficiency
Debt encourages good discipline to make the most of your financial resources, so that can help your company grow to its full potential. While you wouldn’t take on debt for this reason alone, you can consider it a positive side effect of taking on debt.
The incentive to optimize every pound fades when you have a lot of cash on hand. With cash sitting around, it’s easy for spending to expand from necessities to nice-to-haves. However, when cash is tight, the bar for spending is higher because each decision and transaction must be financially justifiable.
On the contrary, debt funding can be used as a strategic tool for growing a business and is often a much cheaper financing option than the alternatives. Due to the competitive environment today, it’s advisable to shop around for the cheapest option that closely fits your needs.